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Monday, August 2, 2010

The 2010 Dodd-Frank Act reformed bank regulation in several ways. It established a systemic risk council, set out a new resolution mechanism for failure of complex financial firms, improved consumer protection, limited risks from derivatives and private trading, and more. However, there were some big things that it did not do. The biggest of those was not to set rules for bank capital.

Establishing a minimum level of capital lies at the very heart of bank regulation. Banks with too little capital (excessive leverage) are at risk of insolvency if they suffer even small losses on loans or other assets. However, higher leverage also increases the rate of return on shareholder capital for banks that manage to remain solvent. Capital standards are thus is a key element of the trade-off between risk and rate of return for banks and other financial institutions.

Bank regulators, who are concerned about the spillover effects of bank failures on the rest of the economy, generally prefer lower risk and higher capital than do banks. (See this earlier post for a more detailed discussion of the risk-return preferences of banks and regulators.) The regulators of individual countries do not act alone in regulating bank capital. Instead, they coordinate their capital standards through the Basel Committee on Bank Supervision. The BCBS has issued a series of regulatory guidelines, beginning with Basel I (1988), later followed by Basel II (2004).

Unfortunately, the Basel II standards were a spectacular failure. They did not prevent the global financial crisis that began in 2007, and may even have facilitated it. The crisis devastated the nonfinancial economy and required costly rescue of dozens of the world's largest banks, including many that, on paper, fully met Basel II capital adequacy standards. The failures of Basel II can be traced, above all, to the fact that they allowed banks to overstate their true amount of capital and understate the risks to which they were exposed.

Many observers think that the simplest measure of capital, tangible common equity (TCE), is the best for gauging a bank's ability to withstand losses. Tangible common equity counts only assets, like loans, securities, or real property, that could be sold by a failing bank to help cover losses in an emergency. It counts as capital only the equity claims of common shareholders that are the first in line to absorb losses. Basel II instead used a more lenient measure of regulatory capital that differed from TCE in two ways. First, it allowed inclusion of certain intangible assets like goodwill and tax loss assets--accounting entries that could indicate future profits for a healthy firm but that offer no protection to one on the brink of insolvency. Second, they allowed inclusion of certain forms of hybrid capital, like preferred stock, that have properties midway between pure equity and debt. Hybrid capital has proved to be a less secure cushion against insolvency under conditions of stress.

In addition, Basel II allowed banks to hold less capital per dollar of safe assets than per dollar of risky assets. At the same time, it allowed understatement of risks, which in turn, allowed banks to get by with inadequate capital. Excessive reliance on ratings agencies, which exaggerated the safety of complex securities, was one problem. Inadequate attention to off-balance-sheet risks was another.

Now negotiations are underway for a new set of international capital standards that will be known as Basel III. Preliminary proposals show a clear recognition of the shortcomings of Basel II. They recommend tightening the definition of capital, relying less on ratings, and paying more attention to off-balance-sheet risks, among other things. Unfortunately, with finalization of Basel III still months away, the goal posts are already beginning to move. At a July 26 meeting, the BCBS announced an intention to water down some of its initial proposals. Some observers are beginning to worry that furious lobbying by banks is paying off, and that the final Basel III standards will again be inadequate. If so, another global crisis will be only a matter of time.

Follow this link to download a free set of classroom-ready slides discussing the meaning of bank capital, the need to regulate it, and the Basel Accords. You may find it helpful to use these new slides together with this earlier set, which discusses bank regulation and the risk-return trade-off in additional detail.

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